Interest Only Mortgage

Interest-Only Mortgage Overview

Interest-only mortgages are not really a type of mortgage. The ability to make only interest payments on a mortgage is actually an option that is available on other mortgages such as adjustable rate mortgages (ARMs) or fixed rate mortgages (FRMs). While the interest-only option may be available on both ARMs and FRMs, it is far more common on adjustable rate mortgages.

Interest-Only Period

The interest-only option period on most mortgages ranges from three to ten years. During that time period the borrower is obligated to pay only the interest due on their loan. No principal payments have to be made during the interest-only period. This means that during the interest-only period, the principal amount due on the loan will remain the same.

Borrowers, may, if they choose, make principal payments during the interest-only period. If they do so, the principal amount of the loan will decrease by the amount of the principal payment. For some interest-only loans, this will result in a lower interest-only payment for the next monthly payment. Others may only recalculate interest-only payments on some predetermined anniversary date.

At the end of the interest-only period the loan payment will be adjusted to include both interest and principal payments. The principal payment will be calculated to fully amortize (pay off) the loan over the remaining term of the loan (for example, if the interest-only period is 10 years on a 30 year loan, then the principal payment will be calculated to fully pay off the loan over the remaining 20 years). This will typically result in a large increase in the borrower's monthly payment.

Advantages of Interest-Only Mortgages

Interest-only mortgages are not for everyone.There are, however, certain circumstances where a borrower may want to consider an interest-only mortgage option. These include:

• Interest-only mortgages have lower payments during the interest-only period of the loan. Because of this:
• Interest-only mortgages may be used by borrowers to qualify for a mortgage that they would not normally qualify for if they had to pay principal and interest. This may allow them to purchase a home, or purchase more of a home than they would have. Borrowers should only consider this if they are confident that their income will rise over time so that they can meet the increased payment demands when the interest-only period is over.
• Interest-only mortgages may be used as a means of providing money to allow the borrower to first pay-off a piggyback second loan which typically has a higher interest rate. The money that would typically go toward the principal payment for the primary loan can be used to pay principal and interest on the second loan.
• Interest-only mortgages can leave available funds for other investments. This typically only makes sense if the borrower has a high degree of confidence in the return on the other investments and they already have significant equity in their home.
• Interest-only mortgages can give a borrower payment flexibility. This can be helpful for individuals who have fluctuating income, such as individuals who receive infrequent commission payments. They can pay only interest when their income is down, and then pay off principal in periods when their income is up. They should only do this if they have confidence in being able to pay off a fair amount of principal or receiving future pay increases so that they can cover the payments when the interest-only period is over.
• Interest-only mortgages may be used by individuals investing in property looking for a quick capital gain from that property. This only makes sense, however, if they have confidence in home prices continuing to rise.
• Interest-only mortgages may also be used as a bridging strategy when selling one home and purchasing another when the borrower must close on the new home prior to selling the old home. In this case, they can use the lower interest-only payment to qualify and purchase the new home. When they sell the old home they can make a large principal payment on the interest-only mortgage significantly reducing the principal balance on that loan and reducing the loan's monthly payments. Borrowers doing this should make sure that their loan does not have any prepayment penalties.

Disadvantages of an Interest-Only Mortgage

There are also significant disadvantages to interest-only mortgages, including:

• Interest-only mortgages typically have higher interest rates than mortgages without the interest-only option. This is some times hidden because most interest-only mortgages are adjustable rate mortgages which typically have lower interest rates than fixed rate mortgages. Borrowers need to be very carful to do an apples-to-apples comparison of interest rates (for example, compare two identical ARMs, one that is interest-only and one that is not).
• There will as some point in the future be a significant increase the monthly payment on an interest-only mortgage when the interest-only period ends. This can cause substantial financial hardship if the borrower's income does not increase significantly over time.
• Some interest-only mortgages may be advertised with no borrower paid private mortgage insurance (PMI) on loans with less than a 20% down payment. What is typically happening in this scenario is the lender is paying the PMI and covering the cost with a higher interest rate to the borrower.

Additional Resources

• Interest-Only Mortgage Payments and Payment Option ARMs from the Federal Reserve Bank.
• Keeping Track of Payments on Interest-Only (IO) Mortgages spreadsheet from The Mortgage Professor's Website.

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